By Andy Ives, CFP®, AIF®
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If ever I was traveling from Los Angeles to Atlanta, I would choose a direct flight with no layovers. I want the most efficient route to my destination. Point A to Point B. Take off, land. Assuming no difference in ticket price and all things being equal, if another LAX to ATL itinerary included a stop in, say, Chicago, would there be any reason to take it? Why pass through another airport in another city when I can fly direct? If I have no personal or professional business in Chicago, it makes no sense for me to go there. A layover in Chicago does nothing but add time, introduce possible delays, and create the risk of a missed connection.
Rollovers from work plans like a 401(k) to an IRA are as common as air travel. Typically, pre-tax dollars are moved into a traditional IRA, and any Roth dollars in the work plan are rolled to a Roth IRA. These are straightforward transactions. But what about after-tax (non-Roth) dollars that may exist in a work plan? (Some plans allow after-tax contributions.) When after-tax dollars are rolled out of the work plan, they are permitted to go to either a traditional IRA or a Roth IRA. In fact, as discussed below, even standard pre-tax plan dollars are allowed to be rolled to either a traditional or Roth IRA.
Historically (assuming no in-plan conversion prior to the rollover), if a person wanted to convert after-tax (non-Roth) or pre-tax plan dollars to a Roth IRA, those dollars first had to be routed through a traditional IRA. Once in the traditional IRA, they could then be converted to their final destination – a Roth IRA.
No longer is this the case. As part of the Pension Protection Act of 2006, Roth conversions can be done directly from company plans. Just like a person can fly direct from LAX to ATL and avoid a layover in another city, after-tax and pre-tax 401(k) dollars can take off from the plan and land directly in a Roth IRA. This is a valid conversion. While a direct rollover to a Roth IRA is not subject to 20% withholding, be aware that pre-tax assets rolled over are includable in income. (Note that if a plan participant elects to do a 60-day rollover, where the check is made payable to the participant, the 20% withholding is mandatory.)
Thankfully, such “mid-air” or “in-flight” Roth conversions are permitted. While routing pre-tax 401(k) plan dollars through a traditional IRA requires an extra step (a “layover” in the traditional IRA), no other major issues typically present themselves. However, routing after-tax (non-Roth) monies through a traditional IRA creates, potentially, more obstacles. For example, the pro-rata rule dictates that a person cannot simply cherry pick the after-tax dollars in their IRA and only convert those. If after-tax dollars are commingled with pre-tax funds in a traditional IRA, pro-rata becomes a significant and on-going concern. While there are ways to deal with the pro-rata rule, a “mid-air” tax-free conversion of after-tax dollars eliminates any pro-rata worries.
Like flying direct, “mid-air” conversions can save time and minimize potential problems. If there is no reason for a layover in a traditional IRA, then why do it? Pre-tax and after-tax dollars can take a direct route from the plan to a Roth IRA. Of course, converted pre-tax dollars are added to income, so be sure you have the money to pay the taxes due on the conversion. Planes can’t fly backwards, so there is no way to reverse the transaction